EM debt: China evokes unjustified fears

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Many foreign investors fail to grasp the transformation of China’s bond markets

Key points

• China’s bond market is set to become the world’s second largest within five years.• Global investors are under-represented.• Structural reforms, such as the growth of the municipal bond market, are a key driver of change.

As China’s bond markets already total $9.4trn (€8.0trn) in size, they are large but are set to grow further. Yet while China is to become the world’s second largest bond market after the US within five years, global investors, with less than 2% of the assets, are under-represented.

There appears to be unjustified fear of investing in China. “China is seen as like the Death Star from Star Wars – a weird freaky attitude that China is just a source of evil with potential to destroy us all,” says Jan Dehn, head of research at Ashmore Investment Management. But China is not the Death Star. It is trying to join the global economic community on terms set by others.

Historically, China’s capital controls have excluded foreign investors from its domestic bond markets. This changed with the implementation of reforms creating channels for direct foreign access. The most recent saw the establishment of the Hong Kong Bond Connect link in July, which allows foreign investors direct access to the domestic bond markets via Hong Kong. The joint announcement by Citibank and Bloomberg that they will be incorporating domestic bonds within their indices should provide further incentives for participation.

The goal of moving from an export-dominated economy to a consumption-led one is driving the development of China’s domestic bond markets. It means moving from an economy where a 47% savings rate forces investors to make volatile investments.

Concurrently, as Hayden Briscoe, Asia-Pacific head of fixed income at UBS Asset Management, points out, the Chinese government wants to lower systemic risk within the banking sector. It has been common practice for provinces and cities to borrow from banks to finance infrastructure projects and ensure economic growth stays on track. But the surge in local debt and non-performing loans – both a result of unprofitable infrastructure projects – has raised concerns with the country’s regulators. This led to the 2015 budgetary law which withdrew the option of bank borrowing, replacing it with the obligation to raise capital through publicly-traded fixed income markets.

As Arnab Das, head of emerging markets macro research at Invesco Asset Management, argues, disintermediating banks through the bond market is a logical approach to diversify and spread risks (and returns). It is also a step towards a market-based system of long term credit and resource allocation. This would imply that credit risks can be diversified and dispersed rather than ultimately representing a fiscal problem, which would encourage over-lending and asset bubbles.

Using a municipal (muni) bond market would also signal that the underlying investments are the obligation of local governments, and cannot be socialised nationally. But, warns Das, it remains to be seen whether the practice of controlled defaults will limit moral hazard or perversely encourage it. It may signal that systemic entities which engage in overlending will be bailed out but insignificant entities allowed to fail.

The main holders of muni debt will be domestic mutual funds held by retail savers as alternatives to equity and property. The existence of lower-risk saving portfolios should require investors to invest less. That should also encourage greater consumption.

The development of the muni bond market is integral to the move towards consumption-led growth based economy. Dehn says it is central to the development of a Chinese mutual fund market. It should also aid the restructuring of the banking system. State-owned financial institutions holding massive portfolios of untradeable infrastructure and property loans could be transformed into modern western modelled institutions.

Such changes require a delicate balancing act. Economists Robert Mundell and Marcus Fleming argue that an economy cannot simultaneously maintain all three policy objectives of an independent monetary policy, fixed exchange rates and a free capital account (the Mundell-Fleming Trilemma). In China’s case, the decision to liberalise the capital account and the currency was taken long ago, with the remaining challenge being one of timing.

As Das points out, China is opening up capital markets while restricting domestic capital outflows. The latter measure is designed to help manage its balance of payments and defeat devaluation expectations that have the potential to become self-fulfilling. China wants to manage its monetary policy independently of the US and the rest of the world.

There is of course an internal contradiction. Inviting non-residents requires an open, two-way flow in the capital markets and capital account as foreigners will want to be able to sell and repatriate as well as enter and buy. Opening up amid concerns about credit, growth or currency risks and resident portfolio diversification needs careful management.

Investors already have a range of onshore debt opportunities from sovereign debt, to quasi-sovereign policy banks, corporate credits and a growing, albeit illiquid, securitisation market. Treasury bonds are issued by the ministry of finance, while policy bank financial bonds are issued by three policy banks: China Development Bank, Agricultural Development Bank of China and Export-Import Bank of China.

Briscoe suggests that investors who perceive Chinese bonds as attractive and are looking to invest for the first time might consider central government bonds and credit-quality policy bank issuers. Investors with the ability to accept greater credit risk may look at state-owned enterprises, local government bonds, local government financing vehicles and corporate issuers.

Emerging market debt (EMD) investors will find sovereign debt yields are lower than in Brazil, Russia and India. Yet they can still be attractive in two scenarios says Dehn. First, if emerging markets suddenly become more risk-averse. In that case, Chinese government bonds will dramatically outperform everything else in EM government bond markets as they are essentially an intra-EM safe haven bet. Second, Chinese debt could be oversold leading to unsustainably high yields. That situation could then be reversed with capital gains for bonds and currency appreciation.

Chinese sovereign debt is important among central banks as well as conventional investors in Special Drawing Rights (SDRs), the reserve assets created by the International Monetary Fund (IMF). The Chinese bond market is unique in the SDR basket in that it has positive real yields and in some cases high nominal yields as well. It is also the country within the SDR system with the highest growth rate and the lowest debt level. Dehn says that for central banks there is a strong case for being overweight in Chinese government bonds at the expense of developed market bonds.

Further down the credit spectrum from sovereign debt are the policy bank bonds which are liquid and seen as quasi-sovereign by investors such as Neuberger Berman. Beneath that means taking on credit exposures in return for extra spread. With credits, there are not only taxation issues but, until 2017, they were trading tight to governments, says Rob Drijkoningen, co-head of EMD at Neuberger Berman. By mid-2017, spreads were starting to widen, increasing credit attractiveness. However, the number of issuers is substantial and the bonds illiquid, especially under difficult conditions. “You can find liquidity in the better rated names, AAA and AA, but it becomes more difficult the weaker the credit,” says Drijkoningen. “It especially becomes difficult on the way down because there is no broad market-making function by investment banks, so you really need to understand who is holding which bonds”.

As a result, investors may need to be as well connected as market-makers in trying to locate, source and sell bonds. But, while it is known who is trading continuously in sovereign debt (which is liquid, trading on bid/offer spreads of 1-2bp) and bank policy bonds, such information can be hard to obtain in relation to credits. There are credit exchanges but they are small so investors have to be patient. For large asset managers it does not represent a practical way of sourcing bonds or getting rid of them, according to Drijkoningen.

Getting liquidity into China’s credit markets is a work in progress. However, the size and quality of China’s debt markets makes it too big for bond investors to ignore.